Edited version of private advice

Authorisation Number: 1052160337971

Date of advice: 13 September 2023

Ruling

Subject: CGT - timing of event

Issues

Question 1

Did CGT event A1, under section 104-10 of the Income Tax Assessment Act 1997 (ITAA 1997), happen to the vendors in relation to the disposal of their lots to the purchaser pursuant to the Contract?

Answer

Yes - CGT event A1 happened when the vendors entered into the Contract on XXXX.

Question 2

Will CGT event C2, under section 104-25 of the ITAA 1997), happen to the vendors in relation to their right to an additional payment pursuant to Clause X of the Contract?

Answer

Yes - CGT event C2 will happen when the payment is made or that right ceases to apply pursuant to Clause X of the Contract.

This ruling applies for the following periods:

1 July XXXX to 30 June XXXX

Relevant facts and circumstances

The vendors own strata titled lots in a building.

Each lot was acquired after 20 September 1985.

Each vendor has been carrying on a business of letting the properties (with respect to their lots).

The lots are not active assets for the purposes of section 152-40 of the ITAA 1997 as they have been mainly used to generate rental income.

Each lot has been held on capital account.

The vendors each entered into a contract for the sale of their lots (Contract) on XXXX.

The Contract allows for the payment of a X% deposit with respect to the purchase price (and applied against the purchase price).

The Contract contains a condition precedent that allows the purchaser to rescind the Contract if that condition precedent is not satisfied.

The condition precedent was satisfied on the same date each vendor entered into their Contract.

The Contract provides for the payment of an additional amount under Clause X, should the purchaser obtain approval to develop the property, to determined according to the formula set out in the Contract. The right to the additional payment will cease to apply X years from the date of completion of the Contract.

Settlement is to take place on YYYY- it may be brought forward to WWWW.

The vendors are related entities.

The vendors and purchaser are unrelated entities, and the transaction (including the settlement period) is on commercial terms/arm's length basis.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 116-20

Reasons for decision

Questions 1 and 2

Summary

CGT event A1 happened when the vendors entered into the Contracts on XXXX. Having regard to the nature of the transactions, the vendors should expect the remission of any penalties and interest when they amend their assessment for the XXXX income year within one month after settlement to account for the net capital gains from the sale of their lots.

The right to the payment under Clause X of the Contract (additional payment right) commences to be owned and is acquired at the time of the Contract (i.e. XXXX). The additional payment right will come to an end when satisfied by the payment of the amount determined under Clause X or ceasing to apply X years from the date of completion of the Contract. CGT event C2 happens at this time, and the vendors will include a capital gain or loss in the year of income in which the payment is made or the X year period from the completion of the Contract applies (as relevant).

Detailed reasoning

Capital gains tax

Section 102-20 of the ITAA 1997 provides that a capital gain or capital loss is made if a CGT event happens to a CGT asset.

Section 108-5 of the ITAA 1997 defines a 'CGT asset' as being:

• Any kind of property; or
• A legal or equitable right that is not property.

CGT Event A1

Under subsection 104-10(1) of the ITAA 1997, CGT event A1 happens if you dispose of a CGT asset.

Under subsection 104-10(2) of the ITAA 1997, you dispose of a CGT asset when a change of ownership occurs from you to another entity.

The effect of CGT event A1 happening is that you make a capital gain if the capital proceeds from the disposal are more than the asset's costs base or a capital loss if those capital proceeds are less than the asset's reduced cost base (subsection 104-10(5) of the ITAA 1997).

The time of the event is when you enter into the contract for the disposal, or, if there is no contract, when the change occurs (subsection 104-10(3) of the ITAA 1997).

The time when a contract is entered into is the time when it comes into existence for general law purposes.

If a contract is subject to a condition, an issue arises whether the condition is a condition precedent to its formation or whether it is a condition precedent to performance of the contract. In the first case, the contract does not come into existence until the condition is met. In the second case, the condition does not prevent the creation of the contract - non-fulfilment of the condition merely entitles a party to terminate the contract: see Perri v. Coolangatta Investments Pty Ltd (1982) 149 CLR 537. (See for example, ATO ID 2004/668 Income tax Capital gains tax: buy-sell agreement - time of CGT event A1).

Capital proceeds

Generally, the capital proceeds from a CGT event comprise the sum of the money you have received, or are entitled to receive, in respect of the event happening and the market value of any other property you have received, or are entitled to receive, in respect of the event happening (section 116-20 of the ITAA 1997).

The money the seller is entitled to receive in respect of the event happening (paragraph 116-20(1)(a) of the ITAA 1997) is limited to the known or ascertainable amounts that are receivable in respect of the CGT event. For the avoidance of doubt, this includes any fixed amounts which the seller is entitled to receive at a later time (section 103-10 of the ITAA 1997).

Deposit

The Commissioner's view on to the nature of deposits in Goods and Services Tax Ruling GSTR 2006/2 Goods and services tax: deposits held as security for the performance of an obligation sets out principles that are relevant in this context in determining whether an amount described as a deposit is an amount that goes against the purchase price.

The Commissioner considers that a deposit paid under a standard land contract serves two purposes. If the contract goes through to completion, the deposit goes against the purchase price. But its initial purpose is as security for the performance of the contract.

The amount of the deposit must be reasonable. What constitutes a reasonable amount for a deposit under a purchase contract is matter of fact and degree.

With regard to contracts for land, Lord Browne-Wilkinson, in Workers Trust & Merchant Bank Ltd v. Dojap Investments Ltd [1993] AC 573, noted that ancient law and custom had established a deposit of 10% as being reasonable as an earnest. It is the Commissioner's view that for a deposit that exceeds 10% in a purchase contract to be accepted as a security deposit to which Division 99 A New Tax System (Goods and Services Tax) Act 1999 applies, suppliers must be able to show that they are at a higher risk of significant losses in the event of default.

Additional amount payable pursuant to Clause 56

Subdivision 118-I of the ITAA 1997 applies in relation to look-through earnout rights created on or after 24 April 2015.

Broadly, the look-through treatment allows the seller to disregard any capital gain or capital loss relating to the creation of the earnout right by treating any financial benefits received (or provided) under the right as increasing (or reducing) the capital proceeds for the business assets (see sections 154-320 of the ITAA 1997).

An earnout arrangement must satisfy the requirements set out in section 118-565 of the ITAA 1997 to qualify for the look-though treatment under Subdivision 118-I:

• The right must be a right to receive future financial benefits that are not reasonably ascertainable at the time the right is created.
• The right must be created under an arrangement that involves the disposal of a CGT asset that causes CGT event A1 to happen.
• The CGT asset that has been disposed of must be an active asset of the entity who disposed of the asset just before the CGT event.
• The arrangement under which the right arises must not allow financial benefits to be provided more than 5 years after the end of the income year in which the CGT event happens.
• All of the future financial benefits must be contingent on the future economic performance of the asset or a business in which the asset is used.
• The value of all of the future financial benefits must reasonably relate to the future economic performance of the asset or business.
• All parties to the arrangement must deal with each other at arm's length in making the arrangement.

Where the asset is not an earnout right for the purposes of Subdivision 118-1 of the ITAA 1997, the principles set out in Draft Taxation Ruling TR 2007/D10 Income tax: capital gains: capital gains tax consequences of earnout arrangements (Withdrawn) remain relevant in determining the taxation treatment of the right to receive an additional amount pursuant to the contract for the sale of a CGT asset that is a separate CGT asset.

In TR 2007/D10 the Commissioner makes the following observations regarding the nature and consequences of earnout arrangements (prior to the introduction of subdivision 118-1 of the ITAA 1997).

In the case of earnout arrangements, the parties to the agreement have entered into a financial arrangement that is independent of the sale transaction from which it arises. The mere fact that the earnout arrangement has its origins in the sale of the original asset is not sufficient justification for treating the earnout arrangement as a merely subordinate part of a larger transaction.

An earnout arrangement is not merely a mechanism by which the parties agree to set an appropriate amount of compensation for the assets delivered in the contract. The deferred payments are not, as a matter of substance, made in respect of the acquisition of those assets. They are paid in respect of a separate obligation under which the seller stands to make a financial gain depending on the economic performance of an asset which the seller has ceased to own. In these circumstances, the CGT provisions recognise that what the buyer has given in respect of the acquisition of the original asset is property in the form of a promise to pay an indeterminate amount of money. Similarly, the CGT provisions recognise that the seller has received property in the form of a right to receive an indeterminate amount of money.

Marren (Inspector of Taxes) v. Ingles [1980] 3 All ER 95 provides useful guidance. In that case, a sale of unlisted company shares was transacted on the basis that the buyer would pay an immediate cash lump sum and an additional amount calculated as a proportion of the list price for the shares at such time that those shares were listed on a stock exchange, should such an event occur. It was found that the character of this transaction was manifested by both the transfer of the shares in question and the financial arrangement involving speculation on whether certain events would occur after the completion of the sale. Earnout arrangements display a similar complexity of character.

The earnout right is property, and a CGT asset, in the hands of the seller.

The earnout right is acquired, for the purposes of section 109-5 of the ITAA 1997, at the time the contract for the sale of the original asset is made. The seller becomes the owner of an enforceable right against the buyer at this time.

The first element of cost base of an earnout right includes the market value of property given, or required to be given, in respect of its acquisition. The market value of property given is worked out as at the time of acquisition of the earnout right (paragraph 110-25(2)(b) of the ITAA 1997). In a transaction of this type, the seller disposes of a CGT asset in consideration for valuable property rights (if the earnout right is the only consideration) or for a combination of money and valuable property rights (if the consideration is a fixed sum plus an earnout right).

If a CGT asset is sold for a combination of money and an earnout right, the first element of the seller's cost base for the right is that part of the market value of the CGT asset (being property) sold that is reasonably attributable to the acquisition of the right (subsection 112-30(1) of the ITAA 1997).

The amount that is reasonably attributable to the acquisition of the earnout right is determined as:

• the market value (on acquisition) of the earnout right;
• the market value of the earnout right plus any money received or receivable on the disposal of the original asset; and
• the market value of the original asset at the time the contract to sell it was made.

More commonly, the CGT event that happens to the earnout right in the hands of the seller will happen by reason of the right 'ending'. This will generally happen in one of two ways:

• by being discharged or satisfied by the payment of an amount or amounts by the buyer; and
• by expiring without any obligation arising on the part of the buyer to pay any additional amount.

In each of these situations, CGT event C2 (about cancellation and surrender and similar endings) happens. In the former case, the right is considered to have ended by being 'discharged' or 'satisfied' (paragraph 104-25(1)(b) of the ITAA 1997). In the latter case, the right is considered to have ended by 'expiring' (paragraph 104-25(1)(c) of the ITAA 1997).

When a CGT event happens in relation to the right, one of the following consequences will follow:

• if the capital proceeds from the event exceed the cost base for the right, the difference is the seller's capital gain;
• if the reduced cost base exceeds the capital proceeds, the difference will be the seller's capital loss; and
• if the capital proceeds are less than the cost base but more than the reduced cost base, the seller will have neither a capital gain nor a capital loss.

Accounting for the capital gain

In Taxation Determination TD 94/89 Income tax: capital gains: in what year of income is a taxpayer required for tax purposes to include a capital gain or loss in relation to land disposed of under a contract which is made in one year of income, but which is settled in a later year of income? (TD 94/98) the Commissioner sets out the following approach to the recognition of a capital gain from the disposal of property:

1. Where the contract is settled in a later year of income, a taxpayer is required to include a capital gain or loss in the year of income in which the contract is made, not in the year of income in which the contract is settled.

2. Where land is disposed of under a contract, subsection 160U(3) of the Income Tax Assessment Act 1936 deems the disposal to have taken place when the contract is made (see Note (1)).

3. However, a taxpayer is not required to include any capital gain or loss in the appropriate year until an actual change of ownership occurs. Settlement effects a change of ownership and a disposal (subsection 160M(1)) which then triggers the operation of subsection 160U(3). When settlement occurs, the taxpayer is then required to include any capital gain or loss in the year of income in which the contract was made (subsection 160U(3)). If an assessment has already been made for that year of income, the taxpayer may need to have that assessment amended.

...

5. Where an assessment is amended to include a net capital gain, and a liability for interest arises under subsection 170AA(1), the remission of interest will be dealt with in each case on its own merits. We would expect, however, that the discretion in subsection 170AA(11) would ordinarily be exercised to remit the interest in full where requests for amendment are lodged, and where relevant, self-amendments are made, within a reasonable time after the date of settlement. In most cases, we would consider a period of one month after settlement to be a reasonable period.

Application in these circumstances

Each lot is a CGT asset.

CGT event A1

The disposal of the lots under the Contracts of sale will trigger CGT event A1.

The time of CGT event A1 is when the vendors entered into the contracts for the sale on XXXX (noting that the condition under Clause X was also satisfied on XXXX).

The vendors' capital proceeds from CGT event A1 include the purchase price (which encompasses the amount described as a deposit in the Contract).

Pursuant to TD 94/89, the vendors may account for the net capital gains from the sale of their lots within one month after settlement.

Relevantly, the transaction between the vendors and purchaser is on an arm's length basis/commercial terms (including the settlement period), and the deposit amount is less than the 10% benchmark that is generally accepted as reasonable for contracts relating to the sale of real property. The transaction does not involve a deferment of the settlement amount under the guise of a deposit, to take advantage of the concessionary treatment afforded under TD 94/89, to preclude the remission of interest (and penalties) where the vendors seek to amend their assessments for the income year ending 30 June XXXX within one month after settlement to include the net capital gain from the disposal of the lots.

CGT event C2

Noting that the lots are not active assets, and notwithstanding the additional amount may not be an earnout payment as generally understood (in the sense it is a future financial benefits contingent on the future economic performance of the asset or a business in which the asset is used), the principles set out in TR 2007/D10 remain relevant

Under section 116-20 of the ITAA 1997, the additional payment right is not an entitlement to money for the purposes of calculating the vendors' capital proceeds from CGT event A1. The right to the additional amount under the Clause X of the Contract, arising from the sale of the lots, is a right to payment of an unascertained sum at a future date that is a separate CGT asset.

The vendors cannot 'look-through' the additional payment right to treat any payments made in relation to it as the capital proceeds in respect of the disposal of the lots.

The additional payment right commences to be owned and is acquired for the purposes of section 109-5 of the ITAA 1997 at the time of the Contract (i.e. XXXX).

The additional payment right will come to an end when satisfied by the payment of the amount determined under Clause X or ceasing to apply X years from the date of completion of the Contract. CGT event C2 happens at this time and the vendors will include a capital gain or loss in the year of income in which the payment is made or the X year period from the completion of the Contract applies (as relevant).